Transcript Cours 4

International Finance
Part 1
Fundamentals of
International Finance
Lecture n° 4
Exchange rate management
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Exchange rate management
Introduction
Goals of the chapter :
Ask whether a flexible exchange rate system is desirable,
Discuss the argument for greater exchange rate fixity
Flexible exchange rate system
Implies a minimum of insitutional design
Carry weaknesses linked to this minimal framework :
• Uncertainty
• Lack of discipline
• Problems of volatility and misalignments
Case for more managed exchange rates
Then leads to problems of speculative attacks if monetary
policy is inconsistent with fixed exchange rate target. 2
Exchange rate management
The case for flexible exchange rates - Arguments
Defined as
« Rates of foreign exchange that are determined daily in
the markets for foreign exchange by forces of demand
and supply… »
Avoid the intervention of the government and the possible
run out of reserves
Automatically adjusts the BOP disequilibria
Speculators facilitate and smooth the adjustment of the
exchange rate, having a stabilising effect
Confer monetary autonomy to a country
Provide insulation from external shocks via exchange rates
adjustements, upward or downward.
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Exchange rate management
The case for flexible exchange rates - Challenges
However, the argument for flexible exchange rates
have been seriously challenged to several extents.
Floating rates since 1973 have exhibited high volatility and
spent long periods away from their long-run fundamental
equilibrium level (misalignement)
Domestic price of
foreign exchange
Supply of foreign
exchange
Seq
Demand for
foreign exchange
Q of foreign exchange 4
Exchange rate management
The case for flexible exchange rates - Challenges
Exchange rate determination models do not seem to prove
empirically that fundamentals drive the exchange rate.
Studies showed that same current account imbalances
persisted after the adoption of floating exchange rates in
1970 ’s and 1980 ’s.
Changes in prices caused by depreciation may not alter
demand for the product (ex. Switzerland, Germany, Japan),
in particular for high quality goods with few substitutes.
Monetary autonomy ? UK example in 1979-1981 where
monetary tightness rise interest rates, causing a huge
capital inflow, leading to exchange rate appreciation,
affecting badly the tradeable sectors.-> few autonomy.
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Exchange rate management
The case for flexible exchange rates - Challenges
Insulation from external shocks?
Full insulation : idea abandoned.
Still a question on whether flexible rates better insulate
the domestic economy. Via, p.ex., appreciation of the rate
in case of rise of foreign demand for domestic exports,
and vice versa.
Empirical results are mixed.
Overall : several exaggerated benefits for flexible
exchange rates.
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Exchange rate management
The benefits of greater exchange rate fixity
Four arguments in favour of some degree of exchange
rate intervention :
The discipline argument : helps to promote lower
inflation.
The need to reduce exchange rate volatility : more
uncertainty can reduce the volume of trade.
The desire to eliminate misalignments : long period of
over- and undervaluation - like displayed in the floating
rates period - results in various cost for the real sector.
The benefits of a single currency
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Exchange rate management
Exchange rate fixity : The Discipline argument
(1) Flexible rates tend to promote inflation (evidence is
mixed and theoretically unlikely)
(2) Fixed exchange rate force countries to contain
inflation : one of the core arguments in favour of EMS.
Consider 2 countries :
• UK : high inflation, and current account deficit
• Germany : low inflation, and current account surplus
• In theory : leads to a tendency of appreciation of the DM :
Bundesbank should sell DM against foreign currencies,
expanding the monetary base, and reducing pressure on S.
• UK : should disinflate, buy Pounds against foreign currencies
to reduce pressure of depreciation.
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Exchange rate management
The Discipline argument
Asymmetry : Germany could sterilise (and avoid a price
rise) by selling bonds against DM, reducing back the
monetary base. UK cannot sterilise much, soon running out
of reserves. -> this asymmetry leads to a disinflationary
bias.
And, the credibility bonus brought by the exchange rate
target reduces the costs of disinflation in terms of
unemployment : agents easily observe the exchange rate
target and believe that inflation will fall -> they adapt their
wage bargaining behaviour.
Exchange rate targets are more efficient (credible)
disinflation tools than monetary growth targets.
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Exchange rate management
Exchange rate fixity : The Volatility argument
Need to reduce exchange rate volatility : more
uncertainty can reduce the volume of trade.
Foreign direct and long-run foreign investment might
also decline in greater exchange rate uncertainty.
Sudden changes in the value of reserve currencies can
be problematic.
However, possible recourse to the forward market, but:
only existing for large currencies,
can be expensive.
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Exchange rate management
Exchange rate fixity : The Misalignment argument
Floating rates have a tendency for persistent departures
from long-run equilibrium
Long period of overvaluation and undervaluation cause
changes in the price of tradeables goods relative to non
tradeables.
• Example : persistent overvaluation, causing industries to become
uncompetitive, but capital and labour are not easily convertible
into other, non tradeable sectors
• -> overvaluation usually leads to unemployment and
underutilisation of resources, and ultimately, to
desindustrialisation.
Also : effect of misalignment on long-term debt accumulated
in foreign currencies : can significantly change the return of
project financed by borrowed currencies.
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Exchange rate management
Exchange rate fixity : The Single Currency
Benefits of a single currency within any country are :
simplification of the profit-maximising computations of
producers and traders
facilitated competition among competitors of the country
promotion of the integration of the economy into a
connected series of markets for the factors of production
If single currency among different countries : accrued
benefits due to the suppression of the transaction costs of
exchanging currencies.
If exchange rate management : part of these listed benefits
could be achieved, compared to a fixed rate regime.
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Single Currency
Costs of a single currency
Costs : of a single currency across different countries:
loss of the exchange rate
loss of the monetary policy
Loss of exchange rate :
Eliminate the possibility of using the exchange rate as a
policy instrument to rectify external equilibria.
• Example : External shock of price fall in steel leads Belgium
(large exporter) to a deficit on its current account.
• Belgium should either deflate (allowing prices to fall) or let the
currency depreciate (or devalue if fixed exchange rate) in
order to restore equilibrium.
• If prices are sticky and cannot fall to restore competitiveness,
deflation (i rises, M falls) will create unemployement.
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Single Currency
Costs of a single currency - loss of exchange rate
Example :
• If Belgium is in a monetary union : no depreciation is
allowed, the economy will go into recession.
• Belgium has no longer a BOP problem, but has a regional
problem within EMU.
Three factors mitigating the costs :
Factor mobility
Openness of the economy
Product diversification
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Single Currency
Costs of a single currency - Mitigation factors
Factor mobility
The greater the mobility of capital and labour, the lower
the cost of joining a monetary union.
Example : asymmetric demand shock : rise of D in region
A, drop in region B. If prices are sticky downwards, region
B will have unemployement, and inflationnary pressures in
region A.
Solution : move unemployed workers from region B to
region A.
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Single Currency
Costs of a single currency - Mitigation factors
Openness of the economy
The loss of exchange is less costly if the economy is more
open.
Reason : exchange rate changes are less effective at
improving competitiveness because money illusion is reduced.
In fixed exchange rates, devaluation increase competitiveness
via the drop real wages following the increase in prices of
imported goods.
In open economies, workers anticipate this change and will
adjust their demand of wage increase to offset the effect.
Product diversity
A demand disturbance in one product is less likely to affect
significantly the exchange rate, if the diversfication is large.
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Single Currency
Costs of a single currency - Loss of monetary policy
Costs : of a single currency across different countries:
loss of the exchange rate
loss of the monetary policy
Loss of monetary policy :
Eliminate the ability to conduct an individual monetary
policy, since monetary policy is directed from the centre
rather than from individual countries.
Many believe that the more similar inflation rates countries
have, the more appropriate candidates they are for a
monetary union.
More generally : the closer degree of policy integration at
macro level, the more easy it is to form a monatery union.
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Single Currency
Criteria for countries to benefit from a single
currency
Similar policy goals
Similar macroeconomic performance
Close inflation rates
Conduction a lot a of trade transactions between one
another.
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